Bonds Vs. Stocks: Similarities & Risks
Both stock and bonds can play a critical role within a long-term investment strategy. Understanding how stocks and bonds differ, how they each generate returns, and their respective risk properties, can help investors develop a portfolio that suits their individual investment objectives.
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Bonds vs. Stocks: Basics
Stocks, which are officially called common shares, represent equity ownership in a corporation. Investors who own common shares become part owners of the business, based on their proportional ownership. Bonds, on the other hand, represent debt that a company has issued, with no company ownership rights being granted to debtholders. Federal, State, and Municipal governments can also issue bonds, in addition to individual companies.
| Stocks | Bonds | |
| What They Represent | Company's equity | Company's debt |
| Returns | Can be received through increase in company share price and/or dividends | Usually received through interest payments (coupons) |
| Voting Rights | Available for some stockholders | Not available for bondholders |
| Bankruptcy Rights | Generally lower priority to receive proceeds | Generally higher priority to receive proceeds |
Editors Note: This article defines "Stocks" as common shares, and doesn't seek to cover preferred shares
Stock vs. Bond: What They Represent
A company issues stocks and bonds as a way of raising capital for short-term needs or future investment. Stocks represent a company's equity, while bonds represent a company's debt which must legally be paid back. Both stocks and bonds can be traded by investors in the secondary market after a company has issued them.
Stock vs. Bond: Returns
Stock returns are driven by increases in a company's share price, as well as through the payment of dividends, which normally represent the return of some company profits to shareholders.
With bonds, investors typically receive interest from the company, and these payments are called coupons. The coupon rate of a bond is set at the time of issuance, and usually does not change except in the case of a floating rate bond. Some bonds, called zero-coupon bonds, don’t pay interest over time, but are issued at a deep discount and mature for par value.
Stock vs. Bond: Voting Rights
Voting rights are typically assigned to common shareholders, although some classes of shares do not offer voting rights. Those that do allow investors to vote on issues that come before the company's board of directors. Examples include votes on whether to accept a takeover offer, or whether to remove a board member from their seat.
Bondholders have no voting rights.
Stock vs. Bond: Bankruptcy Rights
Shareholders and bondholders are treated much differently in the event of company bankruptcy. If a corporation goes bankrupt, bondholders are among the first in line to receive proceeds from a liquidation, or new securities from a restructuring. Shareholders meanwhile are near the end of that line, and will usually only collect any residual value after bondholders have been compensated in full.
It's worth noting that other stakeholders, such as pensioners, current employees, and government agencies, may rank higher in priority to bondholders. In the event of bankruptcy, there's often a significant risk that bondholders are not made whole, although in most cases they will receive something.
Key Takeaway: Stockholders are subordinate to bondholders when it comes to rights of claims against the company.
How Bonds & Stocks Work
Bonds
When investors buy corporate or government bonds, they are purchasing a loan that was issued by that organization. Bondholders are creditors, just like any institution that lends money to a company. The company or government records issued bonds as debt on their balance sheet. The bonds are issued with a coupon rate, which is the rate of interest the company pays bondholders. Bonds are also issued with a maturity date, which could be one year away or as many as 10, 20, or 30 years into the future.
The financial quality of the issuing company, along with the term of the bond, are the primary determinants for assigning a bond yield. Typically longer terms and lower credit ratings are associated with higher bond yields, while shorter terms and higher credit ratings mean companies can issue debt at lower interest rates. Credit ratings are assigned by agencies like Standard & Poor's and Moody's.
Debtholders, except in the case of zero-coupon bonds, usually receive coupon payments monthly, quarterly, or semi-annually. Semi-annual coupons tend to be the standard. At maturity, the company or government entity will return the principal amount invested.
Bond Interest Example
If an investor buys a $10,000 bond with a coupon rate of 4.5%, maturing in 10 years, the company is scheduled to pay the investor $450 every year. When the bond matures, the company will return the original $10,000 to the investor. Over that 10-year period, the investor will have also received a total of $4,500 in coupon payments. The payments are subject to the company's solvency, of course.
Stocks
Investors can own a portion of a company by buying shares of its common stock on a stock exchange, or through an initial public offering (IPO). The more shares an investor holds, the more of the company they own. Shareholders effectively participate in both the profits and losses of the company whose stock they own. Moreover, the value of a company’s shares fluctuate alongside anticipation of company successes and failures, so shareholders often reap benefits before company profits and losses are officially reported.
Stock Gains & Losses Examples
If the company's stock sells for $25 a share and the investor has $2,500 to invest, they can purchase 100 shares. If the company performs well and the share price increases to $37.50, the investor's investment has increased by 50%. Conversely, if the company performs poorly and the share price falls to $12.50, the investor would be looking at a 50% loss. Gains and losses are not locked in until the investor sells the shares.
Bond Market vs. Stock Market
Stocks and bonds are traded differently. To purchase stocks, investors can access any one of 13 registered stock exchanges in the U.S., or an international stock exchange, via their brokerage. To buy or sell bonds, investors must do so over the counter (OTC) because there is no formal exchange for trading bonds.
The Bond Market
Bonds trade over-the-counter (OTC), which is an informal exchange accessed by brokerage firms and institutional investors, such as banks, pension funds, and asset managers. Typically, corporate bonds are issued through an investment bank which can make a primary market for institutional investors.
Retail investors can buy and sell bonds through brokerage firms that make a secondary market in that particular issue. Buying bonds may require more capital; the face value of bonds starts at $1,000 and is typically sold in lots of ten.
The Stock Market
Stock exchanges operate as marketplaces where buyers and sellers meet to trade stocks and other financial instruments, such as exchange-traded funds (ETFs). Stock exchanges, such as the New York Stock Exchange (NYSE), use to be physical meeting places where traders congregated and shouted over each other to get their trades executed.
Today the majority of trading is done electronically in the digital world, mostly through computer programs managed by algorithms that dictate buy and sell decisions for institutional and professional traders. Tens of millions of trades are executed each day.
Investors can access stock exchange listings using a brokerage account. Most brokerage firms require a minimum amount of money to open an account, but many don't require a minimum amount to start buying stocks.
Income from Bonds and Stocks
Investors invest in stocks and bonds seeking a return on their investment. How those returns are earned differs between stock and bond ownership.
Income from Bonds
Investors purchase bonds usually expecting security of capital and a predictable stream of income. When a bond is purchased, the bond yield is locked in for as long as the investor holds the security. Coupons are regularly paid on bonds, most typically every 6 months, and are taxed as ordinary income.
If the bond is held to maturity, the company pays the maturity value, which is typically equal to the original issue amount (except in the case of zero-coupon bonds, strip bonds, or other discount bonds). Although bondholders don’t receive any coupons from zero-coupon bonds, these securities are taxed as if income were received each year.
Income received from U.S Treasury bonds is taxed federally but not by the states. Bonds issued by state or local governments (municipal bonds) are exempt from both state and federal taxes.
If an investor purchases a bond at par (the bond's face amount) and holds it to maturity, it doesn't create a taxable capital gain because they just receive their principal back. However, if an investor purchases a bond on the open market that is selling below its face value, they will recognize a taxable capital gain at maturity, or in any other situation where the bond is divested for more than the purchase price.
Income from Stocks
To generate returns from stocks, investors can collect dividends and/or sell their shares at a higher price than they paid. If an investor bought 100 shares of Apple (AAPL) at $150/share and later sells them at $200/share, that will produce a capital gain of $50 per share or $5,000 on the 100 shares. Capital gains from stocks held for more than one year are taxed at favorable capital gains rates, while gains held for one year or less are taxed as ordinary income.
Conversely, if the investor buys Apple stock at $150 per share and later sells it at $100 a share, this produces a capital loss. Capital losses can be used to offset capital gains as a way to reduce the investor's taxes payable.
- Short-term capital losses on stocks held one year or less can be used to offset short-term capital gains.
- Long-term capital losses can be used to offset long-term capital gains.
An investor will be responsible for paying tax on all net gains, while only $3,000 of net losses can be applied to their taxes from income in any given year.
Important: Investors with complex taxation matters should consult with a tax advisor.
Stock dividends usually represent a distribution of profits from a company. Companies typically pay dividends quarterly, but can declare dividends at different intervals. Investors can keep their dividends as cash income or reinvest them. Regardless, qualified dividends are currently taxed the same as long-term capital gains.
Bonds & Stocks Investment Performance
Historically, stocks have outperformed bonds in terms of their average annual stock market returns. Since 1926, large-cap stocks have returned an average of 10.3%, while long-term corporate bonds returned 6.2%. However, over the past 20 years, large-cap stocks have averaged a 7.47% annual return, while long-term corporate bonds have averaged a 7.96%. (Source: Duff and Phelps. 2021 SBBI Yearbook. U.S. Capital Markets Performance 1926-2020)
During this period from 2001 through 2020, the stock market experienced two economic recessions and two market crashes. Long-term bond returns, meanwhile, have been boosted by declining interest rates. Over the last 2 decades, bonds outperformed stocks in seven of those 20 years. (Source: stern.nyu.edu)
Inverse Relationship of Stock & Bond Performance
Stocks and bonds often have an inverse relationship, especially during periods of turmoil when stock prices are plummeting. During a declining stock market, investors might move their money to lower-risk bonds, which increases their demand and pushes up their prices.
Interest Rates & Bond Performance
Interest rates, and interest rate movements, impact bond performance. For example, a recently issued long-term bond with a 4.5% yield/coupon today would increase in value if interest rates decline. Why? Because this bond's coupons would be more attractive than new bonds issued at a lower yield. Investors would bid its price higher as a result. Conversely, when interest rates rise, that same bond would be less valuable than newly issued bonds, thereby lowering its demand, and by consequence also its fair price.
Key Takeaway: Bonds and stocks often have an inverse relationship, especially during times of stock market turmoil. This means that holding both stocks and bonds in a portfolio can provide diversification benefits.
Bond Risks vs. Stock Risks
Financial theory suggests that higher-risk securities should offer higher expected returns. Stocks are generally more volatile, and seen as more risky than bonds. Investors, therefore, expect higher average returns from equities, and that has proven to be the case over the long term.
However, the greater the risk, the greater the chance of loss. Investors in stocks should be more risk-tolerant, and able to stomach significant losses from time to time. Investors who are risk-averse or want more stability in their investments may want to allocate more of their capital to investment-grade corporate or U.S. Treasury bonds. Here's a breakdown of the distinct types of risk associated with bonds and stocks.
Bond Risks
Government Bond Risk
Investment-grade corporate or U.S. Treasury bonds tend to be more stable and less risky than stocks, but as noted above, lower risk generally means lower returns. Treasury bonds are backed by the U.S. government, and are largely assumed to carry virtually no default risk, but can sometimes experience downward price movements in the intermediate-term due if interest rates rise.
Corporate Bond Risk
- Risk of default by the company: Corporate bonds have varying levels of risks based on the financial strength of the issuing company. Bonds issued by companies with excellent financials and growth prospects are safer, but lower-yielding, than bonds issued by companies struggling with poor financials and growth prospects.
- Issuer may be financially unstable: Investors seeking higher returns bonds, referred to as high-yield or junk bonds, must accept that the issuing company may be on unstable financial footing, or may have deteriorating business prospects. High-yielding bonds exist as a result of investors demanding a higher rate of return for the risk of holding that bond.
- Companies may have trouble covering the interest due on bonds or paying back the bondholder in full at maturity. High-yield bonds tend to be more volatile than investment-grade bonds due to their higher risk.
- Interest rate risk: Bond investors also have to contend with interest rate risk. Generally, when interest rates increase, bond prices fall. If investors don’t hold a bond to maturity, they risk selling the bond for less than they bought it.
Note: Investors seeking greater stability and lower risk can invest in investment-grade corporate bonds, but these come with lower expected returns.
Stock Risks
As part owners of the business itself, stockholders are exposed to the risk that a company's prospects and/or financial situation deteriorate.
Company-specific risks include:
- The possibility that a firm's products and services become obsolete
- The risk that competitors enter the industry with lower prices
- Reputational risk
- The risk of supply disruptions
- Corporate governance risk
- Regulatory risk
Stock prices are also exposed to more broadly defined market risks. If investors become pessimistic about the global economic outlook, geopolitical tensions, political risks, disruptions like a health pandemic, or other issues, they may sell their stock holdings and drive the entire stock market lower. These broad-based market risks have the potential to negatively affect almost any company and their stock price, even those companies whose businesses appear to be performing well.
Important: Although corporate bonds and government treasuries are seen as more stable and secure than stocks, all securities are subject to some types of risks.
Researching Bonds vs. Stocks
Investors performing due diligence into potential investments have a variety of places to find information. Most companies have an Investor Relations (IR) area on their website that provides information on the securities issued by that company, along with presentations and recent announcements.
Company SEC filings can be accessed through Seeking Alpha quote pages.
Seeking Alpha Symbol Page
An alternative source for company filings is the U.S. Securities and Exchange Commission website.
To supplement their own research and analysis, investors can also look for stock and bond ratings reports at brokerages, and rating agencies like Moody's and Standard and Poor's.
For stocks, brokerages assign Buy, Hold, or Sell ratings for stocks. Many use a 5-level system which include "Strong Buy" and "Strong Sell" ratings. Some brokerages use different ratings terms like "Underperform", "Avoid", or "Conviction Buy".
Ratings Summary on Seeking Alpha
Seeking Alpha users are presented with a "Ratings Summary" on security quote pages. The consensus Wall Street analyst rating is presented here alongside the average Seeking Alpha contributor sentiment, and the Seeking Alpha Quant Rating.
Seeking Alpha Symbol Page
Ratings for investment-grade bonds are assigned from high (Aaa from Moody's, and AAA from S&P) to low (Baa3/BBB). Bonds with BB or lower ratings are deemed not investment grade. A "D" rating means the company is already in default.
While ratings from brokerages, bond agencies, and other organizations can be worth reviewing, these ratings aren't infallible. Many investors will remember the Financial Crisis of 2008-2009 and how even many of the most respected research outfits failed to correctly assess the risks embedded in the U.S. housing market.
Seeking Alpha is an excellent source for stock research, and for reading the research and analysis other investors have prepared. At the end of the day, there are no replacements for personally understanding a company's business and learning more about the firm's risks, future prospects, and financials. Knowing as much as possible about the critical aspects of a company can provide a great comfort to an investor and contribute to making well-informed investment decisions.
Premium subscribers here at Seeking Alpha have access to an easy-to-use stock rating screener that reveals the top stocks based on investors' criteria in many categories.
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